Interest Risk Management & Guidelines

Rajat Sikri 1021227, Rohit Dhannawat- 1021229, Saurabh Khator- 1021231 [Pick the date]

Interest Risk Management and Guidelines

Interest risk management means risk resulting from changes in the interest income owing to interest rate fluctuations. It may be viewed from two different but complimentary perspectivesearning sensitivity to rate fluctuations and price sensitivity of

instruments/products to changes in interest rate. Absence of appropriate management of interest rates is one of the primary factors for accentuating the spell of liquidity problems of bank in recent past.

The various types (sources) of interest rate risks are detailed below :y

Gap/Mismatch risk:-It arises from holding assets and liabilities and off balance sheet items with different principal amounts, maturity dates & re-pricing dates thereby creating exposure to unexpected changes in the level of market interest rates.

Basis Risk: It is the risk that the Interest rat of different Assets/liabilities and off balance items may change in different magnitude. The degree of basis risk is fairly high in respect of banks that create composite assets out of composite liabilities.

Embedded option Risk: Option of pre-payment of loan and Fore- closure of deposits before their stated maturities constitute embedded option risk

Yield curve risk: Movement in yield curve and the impact of that on portfolio values and income.

y y

Reprice risk: When assets are sold before maturities. Reinvestment risk: Uncertainty with regard to interest rate at which the future cash flows could be reinvested.

Net interest position risk: When banks have more earning assets than paying liabilities, net interest position risk arises in case market interest rates adjust downwards.

The movement of interest rates affects a banks reported earnings and book capital by changing
y

Net interest income,

Page 2

The market value of trading accounts (and other instruments accounted for market value), and

by

Other interest sensitive income and expenses, such as mortgage servicing fees.

Changes in interest rates also affect a banks underlying economic value. The value of a banks assets, liabilities, and interest-rate-related, off-balance-sheet contracts is affected by a change in rates because the present value of future cash flows, and in some cases the cash flows themselves, is changed. A bank can alter its interest rate risk exposure by changing investment, lending, funding, and pricing strategies and by managing the maturities and repricings of these portfolios to achieve a desired risk profile. From an earnings perspective, a bank should consider the effect of interest rate risk on net income and net interest income in order to fully assess the contribution of noninterest income and operating expenses to the interest rate risk exposure of the bank. In particular, a bank with significant fee income should assess the extent to which that fee income is sensitive to rate changes. From a capital perspective, a bank should consider how intermediate (two years to five years) and long-term (more than five years) positions may affect the banks future financial performance. Since the value of instruments with

intermediate and long maturities can be especially sensitive to interest rate changes, it is important for a bank to monitor and control the level of these exposures.
1

Measurement of Interest Rate Risk

Managing interest rate risk requires a clear understanding of the amount at risk and the impact of changes in interest rates on this risk position. To make these determinations, sufficient information must be readily available to permit appropriate action to be taken within acceptable, often very short, time periods. The longer it takes an institution to eliminate or reverse an unwanted exposure, the greater the possibility of loss. Each institution needs to use risk measurement techniques that accurately and frequently measure the impact of potential interest rate changes on the institution. In choosing appropriate rate scenarios to measure the effect of rate changes, the institution should consider the potential volatility of rates and the time period within which the institution could realistically react to close the position. Gap analysis, duration analysis and stimulation models are interest rate risk measurement techniques. Each institution should use at least one, and preferably a combination of these
Page 3

techniques in managing its interest rate risk exposure. Each technique provides a different perspective on interest rate risk, has distinct strengths and weaknesses, and is more effective when used in combination with another.

Interest Rate Risk Management and Control Procedures :

Each institution needs to develop and implement effective and comprehensive procedures and information systems to manage and control interest rate risk in accordance with its interest rate risk policies. These procedures should be appropriate to the size and complexity of the institutions interest rate risk-taking activities. The use of hedging techniques is one means of managing and controlling interest rate risk. In this regard, many different financial instruments can be used for hedging purposes the more commonly used, being derivative instruments. Examples include foreign exchange contracts, foreign currency and interest rate future contracts, foreign currency and interest rate options, and foreign currency and interest rate swaps. Generally, few institutions will want or need to use the full range of hedging instruments. Each institution should consider which are appropriate for the nature and extent of its interest rate risk activities, the skills and experience of management, and the capacity of interest rate risk reporting and control systems. Financial instruments used for hedging are not distinguishable in form from instruments that may be used to take risk positions. Before using hedging products, each institution must ensure that they understand the hedging instrument and that they are satisfied that the instrument matches their specific hedging needs in a cost-effective manner. Internal inspections/audits are a key element in managing and controlling an institutions interest rate risk management programme. Each institution should use them to ensure compliance with, and the integrity of, the interest rate risk policies and procedures. Internal inspections/audits should, at a minimum, randomly test all aspects of interest rate risk management activities in order to:

____________________
1

Bank of Jamaica, Interest risk management

Page 4

Ensure interest rate risk management policies and procedures are being adhered to;
y y y y

ensure effective management controls over interest rate risk positions; verify the adequacy and accuracy of management information reports; and ensure that personnel involved in interest rate risk management fully Understand the institutions interest rate risk policies and risk limits and have the expertise required to make effective decisions consistent with the interest rate risk policies.

Principles for the Management and Supervision of Interest Rate Risk:

Board and senior management oversight of interest rate risk:

Principle 1: In order to carry out its responsibilities, the board of directors in a bank should approve strategies and policies with respect to interest rate risk management and ensure that senior management takes the steps necessary to monitor and control these risks consistent with the approved strategies and policies. The board of directors should be informed regularly of the interest rate risk exposure of the bank in order to assess the monitoring and controlling of such risk against the boards guidance on the levels of risk that are acceptable to the bank.

Principle 2: Senior management must ensure that the structure of the bank's business and the level of interest rate risk it assumes are effectively managed, that appropriate policies and procedures are established to control and limit these risks, and that resources are available for evaluating and controlling interest rate risk.

Principle 3: Banks should clearly define the individuals and/or committees responsible for managing interest rate risk and should ensure that there is adequate separation of duties in key elements of the risk management process to avoid potential conflicts of interest. Banks should have risk measurement, monitoring, and control functions with clearly defined duties that are sufficiently independent from position-taking functions of the bank and which report risk exposures directly to senior management and the board of directors. Larger or more ____________________
2

Principles for the management and supervision of IRR, BIS

Page 5

complex banks should have a designated independent unit responsible for the design and administration of the bank's interest rate risk measurement, monitoring, and control functions. Adequate risk management policies and procedures

Principle 4: It is essential that banks' interest rate risk policies and procedures are clearly defined and consistent with the nature and complexity of their activities. These policies should be applied on a consolidated basis and, as appropriate, at the level of individual affiliates, especially when recognising legal distinctions and possible obstacles to cash movements among affiliates.

Principle 5: It is important that banks identify the risks inherent in new products and activities and ensure these are subject to adequate procedures and controls before being introduced or undertaken. Major hedging or risk management initiatives should be approved in advance by the board or its appropriate delegated committee.

Risk measurement, monitoring, and control functions

Principle 6: It is essential that banks have interest rate risk measurement systems that capture all material sources of interest rate risk and that assess the effect of interest rate changes in ways that are consistent with the scope of their activities. The assumptions underlying the system should be clearly understood by risk managers and bank management.

Principle 7: Banks must establish and enforce operating limits and other practices that maintain exposures within levels consistent with their internal policies.

Principle 8: Banks should measure their vulnerability to loss under stressful market conditions - including the breakdown of key assumptions - and consider those results when establishing and reviewing their policies and limits for interest rate risk.

Principle 9: Banks must have adequate information systems for measuring, monitoring, controlling, and reporting interest rate exposures. Reports must be provided on a timely basis to the bank's board of directors, senior management and, where appropriate, individual business line managers.

Page 6

Internal controls

Principle 10: Banks must have an adequate system of internal controls over their interest rate risk management process. A fundamental component of the internal control system involves regular independent reviews and evaluations of the effectiveness of the system and, where necessary, ensuring that appropriate revisions or enhancements to internal controls are made. The results of such reviews should be available to the relevant supervisory authorities.

Information for supervisory authorities

Principle 11: Supervisory authorities should obtain from banks sufficient and timely information with which to evaluate their level of interest rate risk. This information should take appropriate account of the range of maturities and currencies in each bank's portfolio, including off-balance sheet items, as well as other relevant factors, such as the distinction between trading and non-trading activities.

Capital adequacy

Principle 12: Banks must hold capital commensurate with the level of interest rate risk they undertake.

Disclosure of interest rate risk

Principle 13: Banks should release to the public information on the level of interest rate risk and their policies for its management.

Supervisory treatment of interest rate risk in the banking book

Principle 14: Supervisory authorities must assess whether the internal measurement systems of banks adequately capture the interest rate risk in their banking book. If a banks internal measurement system does not adequately capture the interest rate risk, the bank must bring the system to the required standard. To facilitate supervisors monitoring of interest rate risk exposures across institutions, banks must provide the results of their internal measurement
Page 7

systems, expressed in terms of the threat to economic value, using a standardised interest rate shock.

Principle 15: If supervisors determine that a bank is not holding capital commensurate with the level of interest rate risk in the banking book, they should consider remedial action, requiring the bank either to reduce its risk or hold a specific additional amount of capital, or a combination of both.

Page 8